Elasticity and its application

Imagine yourself as Punjab wheat farmer. Because you earn all your income from selling wheat, you devote much effort to making your land as productive as it can be. You monitor weather and soil conditions, check your fields for pests and diseases, and study the latest advances in farm technology. You know that the more wheat you grow, the more you will have to sell after the harvest, and the higher will be your income and your standard of living.

One day, Kansas State University in U.S announces a major discovery. Researchers in its agronomy department have devised a new hybrid of wheat that raises the amount farmers can produce from each acre of land by 20 percent. How should you react to this news? Should you use the new hybrid? Does this discovery make you better off or worse off than you were before? We will see that these questions can have surprising answers. The surprise will come from applying the most basic tools of economics – supply and demand to market for wheat.

In any competitive market, such as the market for wheat, the upward sloping supply curve represents the behavior of sellers, and the downward sloping demand curve represents the behavior of buyers. The price of the good adjusts to bring the quantity supplied and quantity demanded of the good into balance. To apply this basic analysis to understand the impact of the agronomists’ discovery we must first develop one more tool; the concept of elasticity. Elasticity is a measure of how much buyers and sellers respond to changes in market conditions allows us to analyze supply and demand with greater precision. When studying how some event or policy affects a market, we can discuss not only the direction of the effects but their magnitude as well.

The Elasticity of Demand:

We noted that consumers usually buy more of a good when its price is lower, when their incomes are higher, when the prices of substitutes for the good are higher, or when the prices of complements of the goods are lower. Our discussion of demand was qualitative not quantitative. That is, we discussed the direction in which quantity demanded moves but not the size of the change. To measure how much consumers respond to changes in these variables, economists use the concept of elasticity.

Elasticity a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

Price elasticity of demand: A measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.

The Price Elasticity of Demand and Its Determinants:

The law of demand states that a fall in the price of a good raises the quantity demanded. The price elasticity of demand measures how much the quantity demanded responds to a change in price. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price.

The price elasticity of demand for any good measures how willing consumers are to move away from the good as its price rises. Thus, the elasticity reflects the many economic, social, and psychological forces that shape consumer tastes. Based in experience, however, we can state some general rules about what determines the price elasticity of demand.

Availability of Close Substitutes:

Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to, others. For example, butter and margarine are easily substitutable. A small increase in the price of butter, assuming the price of margarine is held fixed causes the quantity of butter sold to, fall by a large amount. By contrast, because eggs are a food without a close substitute, the demand for eggs is less elastic than the demand for butter.

Necessities versus Luxuries:

Necessities tend to have inelastic demands whereas luxuries have elastic demands. When the price of a visit to the doctor rises, people will not dramatically alter the number of times they go to the doctor, although they might go somewhat less often. By contrast, when the price of sailboats rises, the quantity of sailboats demanded falls substantially. The reason is that most people view doctor visits as a necessity and sailboats as a luxury. Of course, whether a good is a necessity or a luxury depends not on the intrinsic properties of the good but on the preference of the buyer. For avid sailors with little concern over their health, sailboats might be a necessity with inelastic demand and doctor visits a luxury with elastic demand.